MET - AMDC

Course Instructor: Prerak Parekh Financial Management

January 2010
Assignment 1

The calculations needed for this assignment can be performed either on a calculator or in Excel.

1. In May 2000, the U.S. Treasury issued 30-year bonds with a coupon rate of 6.25%, paid semiannually.
A bond with a face value of $1,000 pays $31.25 (1,000 × 0.0625 / 2) every six months for the next 30
years; in May 2030, the bond also repays the principal amount, $1,000.

(a) What is the value of the bond if, immediately after issue in May 2000, the 30-year interest rate
increases to 7.5%?

(b) What is the value of the bond if, immediately after issue in May 2000, the 30-year interest rate
decreases to 5.0%?

(c) On a graph in Excel, show how the value of the bond changes as the interest rate changes (plot the
value as a function of the interest rate). At what interest rate is the value of the bond equal to its
face value of $1,000?

2. Your company is trying to decide whether it should purchase a copier from Xerox or lease it. The
copier has an expected life of 6 years, after which it has only marginal value (you can ignore any
residual value). If you purchase it, the price is $145,000, payable now, and you would have to pay an
annual service charge of $8,000. If you lease it, you would have an annual payment of $36,000 each
year (for 6 years), which includes service. The lease payment and the annual service charge occur at
the beginning of each year.

The interest rate is 3.8%. Which option is least costly?

3. You are evaluating two possible projects for your company, both of which involve the development of
a new kind of computer mouse. The projects are mutually exclusive, meaning that the company can
invest in only one of them.
Both projects require an initial investment of $32 million to be made in each of the next three years.
Sales and profits will begin in the 4th year, and this is where the two projects differ. Version A, which
is more innovative, is expected to have sales in year 4 of $24 million and cash profits of $7.8 million.
Profits are expected to increase 6% annually. Version B, which is less innovative but cheaper to
produce, is expected to have the same sales in year 4, but profits of $8.9 million. Profits for version B
are expected to increase only 4% annually.

Assume for simplicity that all cashflows occur at the end of the year. The cost of capital for both
projects is 12%.

(a) Which is the better project? How much is each project worth?
(b) You have the opportunity to increase the growth rate of project B to 6%. How much would you be
willing to invest (today) to get this higher growth?

(c) You are not sure that the discount rate is really 12%. W
hat happens to the value of each project if
the discount rate rises to 14% or falls to 10%? Which project is more sensitive to changes in r?
Why?